THE EMERGENCE OF MARKETS

IN

THE NATURAL GAS INDUSTRY

Andrej Juris
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CONTENTS

Opening the Gas Industry to Competition

Determinants of Industry Structure

Regulate or Not?

Structural Models of the Natural Gas Industry

The Emergence of Markets

Natural Gas Market

Transportation Market

Markets in Other Segments of the Gas Industry

Trading Models in the Deregulated Natural Gas Industry

Bilateral Trading Model

Poolco Model

The Bilateral versus the Poolco Model in the Natural Gas Industry

FIGURES

1. Model 1: The Vertically Integrated Natural Gas Industry

2. Model 2: Competition among Natural Gas Producers
3. Model 3: Open Access and Wholesale Competition
4. Model 4: Unbundling and Retail Competition
5. Transitional Model: Unbundling of Pipeline Transportation and Open Access to Distribution
6. Structure of the Wholesale Gas Market
7. Structure of the Retail Gas Market
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The deregulation and restructuring of the natural gas industry in many industrial and developing
countries have led to the development of new markets that have altered the way the industry
operates. As countries have deregulated prices and lowered entry barriers in the industry, many
new participants have emerged, promoting competition in the newly created markets. The
increased competition has benefited all participants in the natural gas industry— through more
efficient pricing and greater choice of natural gas contracts.

Four distinct structural models have emerged in the restructuring of the natural gas industry, with
the traditional model of a vertically integrated industry increasingly replaced by models that
decentralize the industry along horizontal and vertical lines. These models introduce greater
competition and new models of interaction among market participants, and they reflect how far a
country has advanced in its reform of the natural gas industry. With increasing decentralization,
regulation of the industry focuses on pipeline transportation and distribution, the industry
segments with natural monopoly characteristics. The objective of regulation is to protect both the
end users and the participants in the deregulated segments from the market power of companies
operating in the monopolistic segments.

Two major markets emerge as a result of deregulation: the natural gas market, which facilitates
the trading of natural gas as a commodity, and the transportation market, which enables market
participants to trade the transportation services necessary to ship natural gas through the pipeline
system. Competition and open entry are crucial for the efficient functioning of these two markets.
Although the transportation market is affected by the market power of pipeline companies, resale
of transportation contracts introduces competition in this market and facilitates the efficient
allocation of contracts. Intermediaries and spot markets promote efficient pricing and minimize
transaction costs.

With increasing deregulation, markets become more complex, and trading mechanisms are needed
to ensure simultaneous clearing of natural gas and transportation markets at the minimum cost to
the industry. Two main trading models achieve this socially optimal outcome: the bilateral trading
model, which relies on decentralized bilateral negotiations between market participants to reach
this outcome, and the poolco model, which relies on a centralized entity that coordinates
individual transactions.

If properly applied, both models lead to the same outcome. The bilateral trading model has been
the dominant model used in the gas industry, however, because of its simplicity in implementation.
But the poolco model has great potential once problems with sharing and processing information
are adequately addressed.

This paper outlines the main characteristics of the deregulated natural gas industry. It provides an
overview of the main determinants and models of industry structure and the basic principles of
economic regulation in the natural gas industry. It describes markets that have emerged as a result
of deregulation and looks at new markets in storage, metering, pipeline construction, and system
balancing. Finally, it outlines the mechanics of bilateral trading and “poolco” models, which guide
transactions in the natural gas industry. Two companion papers give case studies of natural gas
deregulation in the United Kingdom and the United States (Juris forthcoming a and b).
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Opening the Gas Industry to Competition

Many countries have undertaken substantial structural and regulatory changes in their natural gas
industries in recent years opening natural gas and pipeline transportation markets to competition.
Since 1984 the United States has separated natural gas supply from interstate pipeline
transportation, deregulated natural gas production and the wholesale market, and introduced
competition in interstate pipeline transportation. Another major reformer, the United Kingdom,
partially opened its natural gas market to competition in 1986, when the government privatized
British Gas.

The United Kingdom continued deregulation by further opening the wholesale natural gas market
and promoting the natural gas resale. The most recent measures are aimed at fully separating
pipeline transportation from supply and gradually introducing competition in the retail market. By
1998 the United Kingdom should have the most competitive natural gas industry in the world.

Other countries have followed the lead of these two reformers. Argentina undertook a radical
reform of its gas industry in 1992, when it separated and then privatized natural gas production,
transportation, and distribution. Distribution companies and large end users can now purchase
natural gas directly from producers, bypassing the resale units of pipeline transportation
companies. Mexico opened its natural gas market to competition in 1993, and Hungary separated
and privatized distribution companies in 1994-95.

Many other countries in Asia, Europe, and Latin America too would like to reform their natural
gas industries to improve efficiency and attract new investment. These countries stand to benefit a
great deal from the lessons learned by reform countries.

A government that wants to reform the natural gas industry faces a complex task. It needs to
assess the viability of competition in the industry as a whole and in its segments, identifying those
with natural monopoly characteristics. And it needs to formulate optimal regulatory policies and
introduce mechanisms to support efficient interactions between regulated and deregulated
segments of the industry.

Determinants of industry structure

The viability of competition in the natural gas industry is determined by three factors: technology,
the size of the market, and entry barriers. Technology determines economies of scale and scope
and thus a firm’s optimal (or minimum efficient) size. The size of a market determines how many
firms can efficiently compete in it. Entry barriers determine whether an additional firm can enter
the market, if the opportunity to do so exists. These three underlying factors determine the
efficient configuration of the industry in a static model.

A dynamic model of the natural gas industry incorporates changes in the underlying factors to
reflect the dynamics of the environment in which the industry participants operate. Technological
development, uncertainty about supply and demand, and regulatory changes influence the viability
of competition in the industry in the long run. The viability of competition must be assessed
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separately for each segment of the natural gas industry, because participants use different
technologies in each segment.

The natural gas industry consists of the following segments: production, pipeline transportation,
trading and supply, and distribution. In the reform countries production and trading and supply
are potentially competitive, while transportation and distribution are characterized by natural
monopoly.

Natural gas production consists of the large set of operations necessary to deliver natural gas to
the wellhead, such as exploration, drilling, production, and gathering. Gathering is the
aggregation of natural gas produced by individual wellheads and its delivery to a location such as
a terminal, where it is injected into a pipeline. It is usually considered part of the production,
because producers often own and operate gathering pipelines. Production is characterized by
multiproduct scale economies across the whole set of operations at the firm level, but these scale
economies typically are not large enough to eliminate competition at the industry level. Producers
must incur substantial fixed start-up costs, much of it sunk, first in the acquisition of drilling rights
and technology and then in exploration and drilling. Only then can a producer start producing
natural gas. It is more feasible for one firm to carryout both exploration and drilling than to
separate these tasks because of the uncertainty in searching for natural gas. As a result, the
optimal size of a production firm is large, though still small relative to the natural gas market.
There are more than 100 natural gas producers in the United States, and more than 40 in the
United Kingdom.

Natural gas trading refers to the resale of natural gas in the wholesale market, and supply to resale
in the retail market. (In the United States gas trading and independent gas supply are considered
part of marketing.) Because these two operations are closely related, they are often performed by
the same firm. The gas trading and supply business is a very competitive segment because of the
limited scale economies. Traders and suppliers need little up-front investment to start
operations— a trader needs only a desk, a computer, and a telephone to contact customers and
make deals. As a result, the optimal size of a gas trader or supplier is small relative to the gas
market. This optimal size increases with deregulation of the industry— because markets become
more complex, with increasing use of short-term and financial transactions— but not enough to
pose a threat to competition in the segment.

Natural gas transportation is the set of operations to deliver natural gas from a producer to
consumer markets through high-pressure pipelines. The transportation segment is characterized
by natural monopoly because of the large multiproduct economies of scale resulting from the high
fixed costs of pipeline construction. Most of the fixed costs are sunk because a pipeline has
limited alternative uses. Operating costs are relatively low, because it costs little to move natural
gas through pipelines. There are also economies of scale associated with the multiproduct
characteristics of transportation services. A pipeline company can use the same pipeline system to
offer transportation services that differ in time, location, and other dimensions (such as the
calorific value of natural gas and the intake and offtake pressure of the pipeline). As a result, only
one pipeline company can typically operate in the transportation segment, although large markets
can accommodate several pipeline companies.
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Natural gas distribution consists of the operations necessary to deliver natural gas to the end
users, including low-pressure pipeline transportation, supply of natural gas, metering, and
construction of customer sites. Distribution is characterized by natural monopoly because of
economies of scale in transportation operations. Additionally, there are economies of scope
among various operations of a distribution company, because they are performed by the same
distribution pipeline system. It is still unclear whether the economies of scope are large enough to
prevent efficient unbundling of transportation and supply operations at the distribution level. But
open access to distribution does seem to generate sufficient competition in supply to large end
users.1 Distribution companies typically enjoy exclusivity in natural gas supply in their region, but
an increasing number of countries have instituted open access in distribution.

Regulate or not?

Natural monopoly in pipeline transportation and distribution calls for economic regulation to
prevent the incumbent utility from exercising its market power. The main goal of economic
regulation is to promote economic efficiency. Regulators often pursue additional goals, such as
fairness or transparency, but these should complement rather than substitute for the economic
efficiency goal. Economic regulation employs various mechanisms to regulate the prices of goods
and services, the performance of regulated firms, and market entry.2

Two well-known and widely used regulatory mechanisms are rate-of-return regulation and price
caps. Rate-of return regulation allows the regulated utility to set rates for natural gas such that it
earns no more than a predetermined rate of return on its capital. The regulator approves the rates
and the size of the capital base that is used for calculating rate of return, and prohibits entry in the
utility’s line of business. The targeted rate of return is typically set equal to the rate of return on
capital facing the same risk as the utility’s capital. The utility is assured of earning the targeted
rate of return because the regulator typically allows a pass-through of cost increases to the end
user rates.3

Price cap regulation sets the maximum price that a natural gas utility can charge its customers for
a certain period. After this time, typically three to five years, the regulator reviews the welfare
impact of the price cap and determines a new price cap. The utility cannot increase its revenues by

1
Introduction of open access in distribution had positive results in Argentina, the United Kingdom, and the United
States, where end users benefited from lower prices and greater choice. But pilot programs in retail competition
showed that a local distribution utility can exercise market power through its control of system operation, metering,
or billing. So the benefits of unbundling distribution must be weighed against the costs of potential exercise of
market power and of regulation of distribution.
2
There is a whole body of literature on the theory of optimal regulation and pricing. See Berg and Tschirhart 1988,
Braeutigam 1989, or Laffont and Tirole 1993.
3
The actual rate of return earned by a utility does not always reach the predetermined level because of regulatory
lag, the time between the cost increase and the regulatory decision that approves cost pass-through. In such a case
the regulator asks the utility to adjust its rates so as to recover the difference between the actual and targeted rates
of return in the subsequent period. A utility regulated by rate-of-return regulation seldom achieves the targeted rate
of return in very dynamic markets.
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charging more than the price cap, but it is free to minimize its costs. Since cost cutting could
occur at the expense of safety and reliability, the regulator sets well-defined safety and reliability
standards for the utility. So the incentive for the utility is to operate efficiently.4 All changes in
input costs are absorbed by the utility until the price cap review, unless the regulator allows a
pass-through of some costs (for example, fuel costs).

The economic efficiency goal of regulation implies that the regulated prices of pipeline
transportation or distribution services must reflect their economic costs and maximize social
welfare. This does not necessarily mean that regulators must always set prices administratively.
Instead, whenever possible, regulators should adopt pricing concepts that give a utility incentives
to set optimal prices for transportation and distribution services. Such concepts as peak-load
pricing, Ramsey pricing, and nonlinear pricing promote efficient pricing and benefit all industry
participants.

If competition is viable in natural gas production and trade and supply, prices and entry should be
deregulated to promote efficient markets. If producers, traders, and suppliers are restricted in
their ability to set prices or enter the market, some participants will acquire enough market power
to sustain high prices. Without price arbitrage or entry to discipline incumbent companies, other
market participants incur welfare losses.

Small countries often have limited competition in their natural gas markets, because the markets
are not large enough to support efficient operation by a large number of domestic producers or
suppliers. In these countries regulators should focus on lowering entry barriers rather than on
regulating domestic firms. If entry barriers are low, the threat of entry by foreign competitors can
serve as an effective check on domestic market participants.

Structural models of the natural gas industry

The more than 10 years of deregulation have produced new structural models of the natural gas
industry. Traditional vertical integration is being replaced by de-integration along both vertical
and horizontal lines. The most important structural changes in the gas industry are open access —
opening the pipeline transportation segment to third-party transportation — and unbundling —
separating natural gas supply from pipeline transportation. These changes have led to four distinct
structural models of the natural gas industry.

Vertical integration

Model 1 is the traditional structure of the natural gas industry, where production, pipeline
transportation, and distribution are all performed by one company, an integrated gas utility (figure
1). Typically, such a utility has an exclusive position in natural gas supply to end users, that is, in

4
Formulation of the price cap is very important in determining the efficiency of incentives faced by the utility. For
example, a price cap equal to the weighted average price of all services offered by the utility can harm the utility or
its customers if consumption of services varies a lot. It also neglects the issue of how new services should be
regulated. Setting price caps for individual services equal to their stand-alone costs gives the utility more efficient
incentives than a price cap based on a weighted average price.
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the retail market. An example is Gazprom, the Russian gas company, which is engaged in all
segments of the industry.

An integrated gas utility is usually heavily regulated because of its monopoly position in the retail
market. The regulatory agency typically uses rate-of-return or price cap regulation to promote
economic efficiency and restrict the utility’s market power.

A vertically integrated utility lacks the flexibility required in a dynamic market environment, and
regulation is often insufficient to induce it to operate efficiently. Governments seeking alternative
industry configurations that would address these problems have identified several areas with good
potential for cost savings: production, wholesale transactions, and retail transactions.

Competition in natural gas production

Model 2 separates production from the rest of the industry and introduces competition among
producers, resulting in more efficient production than in model 1 (figure 2). Producers sell natural
gas to a gas utility, which then resells it to the end users. The transactions between the producers
and the utility lead to the development of a wholesale natural gas market, where natural gas is
traded for further resale. A typical example of a model 2 gas utility is British Gas prior to its
privatization in 1986; before it was privatized, it purchased natural gas from more than 40
producers.

In model 2 regulation is needed to restrict the market power of the gas utility relative to both the
end users and the producers. End user prices are regulated in the same way as in model 1. The
price of gas sold by producers to the utility is also regulated. But the optimal way to determine a
purchase price is through competitive bidding, in which producers bid by price for a supply
contract with the gas utility. A price determined through competition reflects the market value of
natural gas far better than does a price set by a regulator.

Monopolistic gas utilities can often prevent the pass-through of cost savings in production to end
users because of distortive regulation or an ability to exercise market power. Governments
therefore seek ways to open pipeline transportation and distribution to competition.

Open access and wholesale competition

Model 3 introduces open access in pipeline transportation, opening the segment to third-party
transportation (figure 3). In this model a gas utility thus provides two kinds of service: supplying
natural gas to end users and supplying transportation services to large end users and other eligible
industry participants that purchase natural gas independently in the wholesale market.
Alternatively, a gas utility is separated vertically into a pipeline company and several distribution
utilities, and they provide open access to their pipeline networks.5 The gas industry in the United

5
There are many variations on the open access regime, depending on the pressure level at which pipelines are
subject to open access. Determining the threshold level is important in ensuring optimal investment in the gas
industry. If the threshold is too high, many large end users find it cost-effective to bypass low-pressure, non-open-
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States between 1985 and 1992 was a typical example of the model 3 gas industry, as was the U.K.
gas industry before British Gas was unbundled into a gas supplier and a pipeline operator in 1996.

The open access regime promotes efficiency in the wholesale gas market and benefits market
participants. Producers benefit because open access dramatically increases the number of buyers,
eliminating the monopsony problem in model 2. Downstream industry participants, such as
distribution utilities or large end users, benefit from direct access to the production segment and a
greater choice in gas supply.

But pipeline companies are in a more difficult position than in models 1 and 2 because they have
to coordinate transportation of their own and third-party natural gas through the pipeline
network. This coordination can be achieved by introducing market mechanisms that optimize
interactions among market participants and the operation of the pipeline system in deregulated
natural gas markets. Such coordination can be facilitated by the trading mechanism described in
the section below on trading models.

Transactions in the wholesale natural gas market are typically conducted on a bilateral basis, but
increasing complexity calls for intermediation of these transactions. The acquisition of natural gas
and transportation services is often complex, and for some market participants it may be too
difficult and costly. High transaction costs discourage smaller market participants from utilizing
open access, despite opportunities for cost saving. This creates room for natural gas traders,
which aggregate demand and supply for a number of smaller market participants by purchasing
natural gas and transportation services on their behalf. Traders charge fees for intermediating
transactions and minimize the costs of natural gas and transportation services by buying large
quantities and arbitraging across available prices. Competition among traders is crucial to
minimize their fees and to maximize the benefits for their clients.

There are three important regulatory tasks in the model 3 gas industry: to protect end users from
the monopoly power of gas utilities, to promote competition in the wholesale gas market, and to
restrict the market power of pipeline companies relative to the users of their pipeline networks.
End user prices are regulated, using rate-of-return or price gap regulation. Wholesale gas prices
are deregulated if there is sufficient competition in the market. If competition is limited, regulators
should focus on removing entry barriers rather than on directly regulating prices, because
regulating wholesale prices does not promote the development of competitive trading.

The price of a transportation service, or the access price, is one of the most important factors in
achieving competition and efficiency in the wholesale market. The reason is that unregulated
pipeline companies can charge excessive access prices or foreclose access to maintain their
monopsony power. One way to determine an optimal access price is through the efficient
component pricing rule, which says that the access price must recover the pipeline’s costs of
providing transportation services to a third party and the pipeline’s profits forgone in gas supply
operations lost to competition. This price gives a pipeline company the right incentives to provide

access pipelines by constructing a connection to a pipeline that makes them eligible for open access. This may
result in overinvestment in pipelines.
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open access, while it ensures that only those users that paid less for wholesale natural gas than the
pipeline company will consume transportation services.

Unbundling and retail competition

Model 4 introduces unbundling— the separation of natural gas supply from pipeline transportation
and distribution— and full deregulation of natural gas markets (figure 4). The main motivation for
unbundling is an ability by pipeline companies to restrict competition in the wholesale gas market
through nonprice measures, such as offering low-quality transportation services.

Unbundling eliminates this distortion and creates a level playing field for all participants in the
natural gas market. In addition, it facilitates the development of a large number of supply
companies that purchase natural gas in the wholesale market, resell it downstream, and use the
transportation services of pipeline and distribution companies. Competition among supply
companies pushes down their resale markups and thus facilitates the pass-through of cost savings
from the production segment to the end users.

Increasing competition in and deregulation of the natural gas market eliminate the need for price
regulation at the wholesale level and call for regulatory mechanisms that give gas companies more
pricing flexibility at the retail level. Rate-of-return regulation greatly restricts pricing flexibility
and so is less optimal for model 4 than price cap regulation.

In model 4 the natural gas market undergoes significant transformation to accommodate the
variable requirements of market participants, which seek more flexible trading and contractual
arrangements than in model 3. Natural gas is increasingly traded through short term contracts to
balance supply and demand in the short-term and give market participants the flexibility they need.

The development of a short-term, or spot, market promotes efficiency in the entire gas market. As
a spot market becomes more liquid, the spot price moves toward the short-run marginal cost of
gas, which reflects the market value of natural gas at the location of the spot market. Because
prices are continuously determined in a liquid, competitive market, the pricing of natural gas
becomes more efficient. Market participants use spot prices as a reference price in bilateral gas
supply contracts, and so as a result, most natural gas is traded at spot prices.

Short-term gas trading generates volatility in volume and price, increasing the uncertainty of
demand for transportation services. In some periods demand can exceed available capacity; in
others, it may fall below constructed capacity. Pipeline companies respond by selling both firm
contracts, which allow market participants to purchase transportation services with high
reliability, and interruptible contracts, under which market participants purchase services with low
reliability. Pipelines also use gas flow management techniques to minimize swings in demand and
maximize gas flows through the system.

Unbundling introduces a need for simultaneous clearing of natural gas and transportation markets.
Market participants acquire natural gas based on the availability of transportation, and vice versa.
A mismatch wastes resources, because some participants are left with excess natural gas or with
 11

reserved pipeline capacity that goes unused. A match can be achieved only when market
participants have available the same volumes of gas supply and transportation contracts. This
requires the creation of a short-term transportation market, where pipeline companies and
transportation contract holders offer available capacity for sale. An alternative is to adopt a
“poolco” trading mechanism that ensures simultaneous clearing of natural gas and transportation
markets (see the section below on the poolco model).

Large variability in contracts increases the complexity of pricing transportation services. Although
pipeline companies mostly maintain their market power, they need pricing flexibility to react to
changing market conditions. Regulators should therefore use price caps or another regulatory
mechanism that gives pipelines pricing flexibility while also promoting efficient relative prices.

No gas industry has developed to a full-scale model 4 structure. The United Kingdom should
reach a model 4 structure in 1998 when it introduces full retail competition, however, and the
U.S. natural gas industry is moving in this direction. Both countries have unbundled pipeline
transportation and introduced open access in distribution— a typical configuration for a gas
industry in transition from model 3 to model 4 (figure 5).6 Open access in distribution is limited to
end users with consumption of a certain size (2,500 therms a year in the United Kingdom),
because the high costs of metering make competition nonviable in residential gas supply. In
addition, an incumbent distribution company can discourage use of open access by offering low-
quality or imprecise metering services to independent suppliers.

6
The United Kingdom and the United States also introduced retail competition on a small scale in some regions.
For example, a pilot program gave 500,000 residential customers in the southeast of England an option to choose
their natural gas supplier in 1996. Similar pilot programs were introduced in Pittsburgh, New Hampshire, and
many other locations throughout the United States.
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The Emergence of Markets

A vertically integrated gas industry has only one market, where natural gas and transportation
services are sold at the consumption site as a single product, or “bundle.” Open access and the
unbundling of pipeline transportation have led to the creation of two main markets, where natural
gas and transportation are traded separately.

Natural gas and transportation markets are divided into several submarkets, based on the
characteristics of traded products. Product characteristics are determined by the dimensions of the
contracts for natural gas supply and transportation, such as time of service, reliability of service,
delivery location, type of financial settlement, and quantity and quality of natural gas. The
variability in the contracts has led to the development of such submarkets as long-term and short-
term markets and physical and financial gas markets.

The variability of contracts benefits industry participants because they can enter into contracts that
best suit their needs. Each participant can form a contract portfolio that minimizes their costs and
risks and maximizes their benefits. It is important that a participant’s choice not be distorted by
regulation, which results in suboptimal contracting and imposes unnecessary transaction costs.
Where competition has eliminated concerns about market power, regulators should put great
effort into promoting decentralized contracting among market participants.

The opening of wholesale and retail markets to competition has initiated a search for “markets” in
all segments of the natural gas industry. Some countries have introduced competition in storage,
metering and installation of meters, construction of pipelines and customer sites, and pipeline
system balancing.

Natural gas market

In natural gas market natural gas is traded as a commodity, separate from transportation services,
in the form of gas contracts. Although these contracts have multiple dimensions, they are
differentiated primarily by the purpose of the transaction, whether for physical delivery of gas or
for management of price risk. The use of contracts thus divides the gas market into two
submarkets— physical and financial.

Physical gas market

In the physical gas market natural gas is traded under contracts for physical delivery of gas,
physical gas contracts (sometimes referred to as cash gas contracts). Market participants include
producers, traders, suppliers, pipeline companies, and distribution utilities, depending on the
structural model of the gas industry. The physical gas market exists in all structural models,
although natural gas is bundled with transportation in models 1 and 2. Two dimensions of physical
gas contracts divide the physical gas market into several submarkets: the purpose of the
transaction and the duration of the contract.
 13

Wholesale and retail gas markets. Purchases of natural gas for further resale take place in the
wholesale gas market. Purchases of natural gas for end use take place in the retail gas market.
Wholesale transactions are all those concluded among producers, traders, suppliers, and pipeline
and distribution companies; retail transactions are those between suppliers and end users.

The structure of wholesale and retail markets is important for the efficiency of pricing in them.
Strong competition in these markets increases the economic efficiency of decentralized pricing
and reduces the need for price regulation, while a lack of competition raises concerns about
market power and price efficiency and calls for price regulation.

Each structural model of the gas industry has a different structure in its wholesale and retail
markets and thus a different potential for the optimal pricing of natural gas (figures 6 and 7).
Model 1 has a nonexistent wholesale market because all natural gas transactions are conducted
internally by a single vertically integrated company that also monopolizes the retail market. Model
2 has limited competition in both the wholesale and the retail markets. Prices of natural gas in
models 1 and 2 are regulated to prevent excessive pricing by the dominant gas utilities. Models 3
and 4 have relatively competitive natural gas markets, and model 4 has a more competitive
transportation market than model 3.

Long-term gas contracts and development of a spot market. Gas contracts can be divided based
on their duration:
• Short term— for supply of up to one calendar month.
• Medium term— for 1 to 12 months of gas supply.
• Long term— for more than one year.

Longer contracts become increasingly variable, because they reflect the specific requirements of
each gas supply deal. Comparisons of long-term gas contracts are therefore complicated, because
they must take into account so many dimensions.

Long-term supply contracts are the traditional way of acquiring gas. Utilities and their customers
agree on prices and on the total volume of gas to be supplied over the life of the contract and then
specify volumes for each year, quarter, or month. Long-term contracts reduce supply and price
risks, but they provide little flexibility for adjusting supply and demand in response to changing
market conditions. Pipeline companies often face excess demand during extremely cold weather,
because gas prices do not reflect the short-term economic value of natural gas. Demand in peak
periods is often controlled through administrative rules rather than prices, resulting in inefficient
resource allocation.

Deregulation of the gas industry and greater flexibility in supply diminish the importance of long-
term supply contracts and give rise to medium- and short-term contracts. In model 3 or 4 market
participants need to balance their gas supply and demand in the short term. This need leads to the
development of a spot market, where producers, traders, suppliers, distribution utilities, and large
end users trade natural gas on a daily basis. Market participants enter into contracts of different
duration, building a contract portfolio that minimizes supply and price risks in both the long and
the short run.
 14

By generating price signals about the market value of natural gas, spot markets promote efficiency
in the natural gas industry. A spot market usually develops in an area with a high concentration of
buyers and sellers, such as at a pipeline interconnection near a large metropolitan area or at a
terminal in a gas-producing region. The aggregation of supply and demand increases the liquidity
of the market and boosts competition among market participants.

If there is competition among market participants, short-term (spot) prices follow the short-run
marginal cost of natural gas. This means that the spot prices of natural gas reflect its economic
value at a particular time and location (at the spot market), and market participants, facing
efficient prices, can make optimal decisions about their trading strategies. But spot prices tend to
be volatile because they change in response to changes in underlying factors of supply and
demand, such as weather, available pipeline capacity, or consumption pattern. Market participants
become exposed to this price risk because they are unable to predict the future price of natural
gas. Their demand for tools to minimize price risk leads to the development of a financial gas
market.

Financial gas market

The financial gas market is the marketplace where financial gas contracts are traded. A financial
gas contract is used primarily for managing price risk and is not necessarily for physical delivery.
Participants in the financial gas market come from all segments of the gas industry. Because
transactions in this market involve the transfer of risks among these participants, intermediation
plays an important role. The main intermediaries are traders and financial institutions, such as
banks and organized exchanges.

Financial gas contracts are highly variable because of the heterogeneity of needs of market
participants. The most common types of contract are forward contracts, swaps, futures contracts,
and options.7

• A forward contract is a supply contract between a buyer and seller that obligates the buyer to
take delivery, and the seller to provide delivery, of a fixed amount of a commodity at a
predetermined price at a specified date. Payment in full is due at the time of or following
delivery. (By contrast, for a futures contract settlement is made daily, resulting in partial
payment over the life of the contract.)

• A swap is custom-tailored, individually negotiated transaction designed to manage financial

risk, usually over a period of 1 to 12 years. Swaps can be conducted directly by two
counterparties or through a third party such as a bank or brokerage house. The writer of the
swap, such as a bank or brokerage house, may elect to assume the risk itself or manage its
own market exposure on an exchange. Parties exchange payments based on changes in the
price of natural gas, while fixing the price they effectively pay for physical delivery. The

7
The definitions of financial gas contracts draw on the U.S. experience. They are from U.S. Department of Energy
1995 and NYMEX [1996].
 15

transaction enables each party to manage exposure to natural gas spot prices. Settlement is
usually in cash.

• A futures contract is a represents a legal agreement between a party that opens a position on
the futures market to buy or sell natural gas and the commodity exchange. The party agrees to
accept or deliver, during a specified month, a certain quantity of natural gas meeting quality
and delivery conditions described by the exchange. If delivery takes place, it occurs during the
delivery month at a prescribed settlement price. Futures contracts are traded exclusively on
regulated exchanges and are settled daily based on their current market value.

• An options contract gives its holder the right, but not the obligation, to purchase or sell the
underlying futures contract at a specified price within a specified period in exchange for a one-
time premium payment. The contract also obligates the writer, who receives the premium, to
meet these obligations.

A financial gas market tends to develop once the physical gas market has reached a certain
maturity and most natural gas is traded under short-term contracts. Since few countries have a
liquid and mature spot market, the financial gas market is relatively new to the gas industry. Only
the United States has a well-developed one.

Swaps and forwards are usually among the first financial gas contracts developed. They tend to be
customer-specific contracts, developed by financial intermediaries and traders to suit the needs of
individual clients— producers, distribution utilities, and large end users seeking to minimize the
price risk they face in the physical gas market.

Demand for financial gas contracts increases as the physical gas market matures. The
concentration of gas trading in spot markets facilitates the development of standardized financial
gas contracts, such as futures and options contracts, that are developed and supplied by organized
exchanges. For example, the New York Mercantile Exchange (NYMEX) and the Kansas City
Board of Trade (KCBOT) in the United States have introduced standardized natural gas futures
and options contracts for delivery in four major spot markets in the United States and Canada (see
Juris forthcoming b).

Financial gas contracts serve two main purposes. They minimize the price risk in the natural gas
spot market, and they minimize the basis risk resulting from the imperfect match between physical
and financial gas contracts. They also serve as an instrument for speculation and price arbitrage in
the gas market.

Minimizing price risk. Market participants minimize the price risk in the natural gas spot market
by taking positions in the financial gas market, sometimes referred to as hedging. Financial
contracts enable market participants to take positions in cash (or physical) and financial gas
markets to reach an acceptable level of risk. Different levels of risk aversion and the complexity of
the gas market create room for market participants to engage in mutually beneficial transactions.
 16

Transactions in the financial gas market involve the transfer of price risk between two market
participants in exchange for payment. A market participant with high risk aversion is willing to
pay a higher premium to get rid of a certain amount of price risk than a participant with low risk
aversion. If the participant with low risk aversion can hedge against the price risk, it can acquire
the price risk from the participant with high risk aversion. The two participants can then split the
difference in premium, and both will be better off than if they minimized the price risk separately.

In practice, price risk cannot be diversified away completely because of systemic risk, the risk that
is inherent to the market and cannot be diversified away. Market participants can diversify away
only nonsystemic risk, that is, contract- or customer-specific risk. But this requires a sophisticated
understanding of hedging strategies and the functioning of markets. The nonsystemic risk of a
contract can be diversified away through a portfolio of cash and financial gas contracts that best
approximates the market (that is, one that has coefficient beta equal to 1).

Gas traders and other intermediaries are much better able to diversify away nonsystemic risk than
other market participants. They take nonsystemic price risks from producers, distribution utilities,
and other market participants in exchange for premiums and then diversify these risks away by
taking positions in physical and financial gas markets. The cost of hedging their positions is lower
because they are less risk averse and more sophisticated in hedging strategies than other market
participants. Competition among traders pushes premiums down to the least cost of price risk
hedging and thus benefits all market participants engaged in financial gas transactions.

Minimizing basis risk. The use of financial gas contracts that differ in one or several dimensions
from the underlying physical gas contract may result in a difference in the qualitative
characteristics of contracted and delivered natural gas. This risk is the basis risk, the uncertainty
about whether the cash-futures differential will widen or narrow between the time a hedge
position is implemented and the time it is liquidated (NYMEX [1996]). The basis risk depends on
three price relationships:

• The relationship between the price of the futures contract and the spot price of gas. This
represents cash-futures basis.
• The relationship between the spot price at the futures contract delivery point and the spot
price of a similar but not identical commodity at the same location. This is intercommodity
basis.
• The relationship between the spot price at the futures delivery point and the spot price at a
different location. This represents locational basis.

Strategies to minimize basis risk differ depending on the type of basis risk involved. Cash-futures
basis risk can be minimized by a financial gas contract that specifically addresses the problems.
For example, participants in the U.S. financial gas market use the Alternative Delivery
Procedures, which allow them to minimize cash-futures price differentials in the period between
the expiration date of a futures contract and the start of physical gas delivery. This period ranges
from one to five days, depending on the type of futures contract.
 17

Hedging intercommodity basis risk is a complex operation that varies from case to case,
depending on the kind of commodities involved. If the commodities are commercially traded,
market participants can minimize basis risk by taking positions in cash and financial markets in the
relevant commodities. If qualitative differences in a commodity are very small and are not
commonly traded in the market, such as the difference in the calorific value of natural gas,
hedging tools may not be available. In such a case parties must protect themselves by explicitly
defining delivery conditions and providing for penalties in the gas supply contracts.

Locational basis risk can be managed by a financial gas contract created specifically for this
purpose. For example, participants in the U.S. gas industry can use Exchange of Futures for
Physicals contracts (EFPs), which allow them to hedge the locational basis risk for almost any
delivery location in the United States. Naturally, the efficiency of hedging by EFPs depends on the
liquidity of EFPs with the same delivery locations, which in turn depends on the size and liquidity
of the spot gas market at a particular location. As a result, EFPs provide effective hedging of
locational basis risk only at the most commonly used locations, such as large market centers.

Transportation market

A transportation market is a market where transportation services— pipeline capacity and natural
gas shipments for delivery of natural gas to a desired location— are sold in the form of
transportation contracts. The contracts are sold by pipeline companies to shippers. Transportation
contracts are either firm or interruptible, depending on the reliability of the services they offer.
Holders of firm transportation contracts may resell them in the secondary transportation market if
regulation permits such transactions.

The transportation market emerges only in the model 3 natural gas industry, where pipeline
companies offer open access to their pipeline grids. The market develops further with unbundling
and the introduction of retail competition. Model 4 has a fairly developed transportation market,
where industry participants trade transportation contracts for gas shipments in all pipeline grids.

Primary transportation market

The primary transportation market facilitates the initial distribution of transportation contracts.
The contracts give the shippers that buy them the right to transportation services under the
conditions specified. The most common conditions relate to the size of reserved capacity, the size
of natural gas shipment, the location of points of injection and withdrawal, pipeline pressure, the
time and duration of service, service reliability, and charges for capacity and throughput.

Characteristics of service determine the structure of the contracts, with the most important being
duration and reliability. Duration-based transportation contracts are divided into long-, medium-,
and short-term contracts, linking them to the duration of gas supply contracts and facilitating
simultaneous clearing of natural gas and transportation markets in an unbundled natural gas
industry.
 18

Reliability-based transportation contracts can be divided into two major categories: firm and
interruptible. A firm transportation contract gives its holder the right to capacity and
transportation over the whole life of the contract, regardless of the season. It specifies the
maximum daily quantity of gas that can be transported through the pipeline, points of injection
and withdrawal, and charges for reserved capacity and transportation service. The holder of the
contract can ask for shipment of natural gas up to the maximum reserved capacity (capacity
utilization is measured by the load factor, calculated as the ratio of average daily capacity usage to
the maximum daily reserved capacity). This request is usually made through notification of the
pipeline company about the volume of natural gas to be shipped on the next day, or “nomination.”

An interruptible transportation contract gives its holder the right to ship a specified volume of
natural gas within a certain period, for example, within a particular month. But the timing of
transportation is determined by the pipeline company according to the availability of capacity.

There are also hybrids of firm and interruptible contracts, such as no-notice or limited firm
transportation contracts. A no-notice firm transportation contract gives its holder the right to the
maximum daily reserved capacity, but the holder does not have to maintain a daily balance
between nominated and delivered natural gas. A limited firm transportation contract offers firm
transportation service, but the service is subject to interruption for a specified amount of time
each month, say, up to 10 days.

The primary transportation market is regulated because of the natural monopoly characteristics of
pipeline transportation (see the section above on the determinants of industry structure).
Governments often regulate prices, investment, contracts and delivery conditions, and market
access.

The nature of contracting for transportation services varies with industry structure and regulation.
Vertically integrated natural gas companies typically offer long-term firm transportation contracts
that specify the total volume of gas to be delivered to the users over the life of the contract. Users
then specify monthly or quarterly deliveries that must add up to this total contracted volume by
the end of the contract. Long-term contracts give pipeline companies and shippers certainty in
demand and supply, and they give pipeline companies the ability to recover their fixed costs
through revenues from contracted capacity.

Deregulation of natural gas markets creates a need for flexible transportation services. Market
participants need to balance supply and demand in the short term, which is possible only if a
natural gas supply contract is matched by a transportation contract in all major dimensions.
Pipeline companies respond to this need by offering medium- and short-term transportation
contracts and flexibility in the choice of injection and delivery points. This response must be
facilitated by a regulatory change introducing a more flexible regulatory environment for the
pipeline companies and creating a secondary transportation market. For example, in 1992 the U.S.
Federal Energy Regulatory Commission required all pipeline companies to provide more delivery
and injection points in their pipeline systems and offer their customers no-notice, balancing, and
storage services. It also changed the formula for calculating transportation rates and introduced
the capacity release program, a secondary market with firm transportation contracts.
 19

Secondary transportation market

Holders of unused transportation contracts resell them in the secondary transportation market.
Buyers and sellers in this market come from all segments of the gas industry, although pipeline
companies are typically excluded because of market power concerns.

The resale of transportation contracts promotes the efficiency of the transportation market and
facilitates simultaneous clearing of natural gas and transportation markets. The need to resell
contracts arises as a result of short-term changes in supply and demand for individual users which
often lead to a situation in which some users do not utilize all their contracted pipeline capacity
while others lack sufficient capacity to meet their needs. In the absence of a secondary market, the
unused capacity lies idle, with the result that resources are wasted and trade opportunities lost. In
addition, potential buyers lose the benefits of having more natural gas available at their desired
location. Allowing the resale of transportation contracts therefore benefits the entire natural gas
industry.

If transportation contracts establish property rights and are transferable, holders can trade them
freely (though notification of the pipeline company about the change of contract ownership may
be required) and the secondary market flourishes. Firm capacity contracts that give their holders
the right to reserved capacity may be transferable, for example, depending on the prevailing
regulation.

If transportation contracts establish property rights but are not transferable, holders can engage in
a side deal, delivering natural gas for a third party. The owner of the natural gas pays a
transportation fee to the contract holder, who in turn pays the pipeline company the rate specified
in the contract. The secondary market exists, but the complicated trading procedures harm market
efficiency because high transaction costs discourage some users from trading their unused
capacity.

If transportation contracts do not establish property rights, they cannot be traded, and the
secondary market does not exist, at least officially (but shippers can still engage in side deals to
match their natural gas and transportation contracts, as in the case of nontransferable
transportation contracts). This is the worst possible case because the potential benefits of
capacity resale are not realized.

Regulation of the secondary transportation market is unnecessary if there is competition among

buyers and sellers of transportation contracts. The price of a firm transportation contract resold in
a competitive secondary market should reflect the short-run marginal costs of pipeline operation
and the opportunity costs of capacity. This pricing mechanism allows the prices of capacity and
shipping services to adjust to changes in short-term supply and demand. Thus, for example, prices
for pipeline capacity would be high during peak periods, when demand exceeds supply, but
approach zero during periods of excess supply. By contrast, the price for shipping natural gas
would be relatively low and constant because of the relatively low and constant marginal
operating costs.
 20

Secondary trading of transportation contracts can take several forms. A typical trading
arrangement is an auction where interested shippers bid by price for available transportation
contracts. Auctions are used for trading both long- and short-term transportation contracts,
though rigorous auction procedures sometimes discourage resale of short-term contracts because
of the time requirements.

Another common form of trading is bilateral dealing. This form of trading facilitates the resale of
all types of transportation contracts because it gives shippers much flexibility in negotiating the
conditions of transactions.

Trading may also take place in a spot market, where shippers actively trade short-term
transportation contracts. Spot market trading requires standardizing transportation contracts
across all important dimensions in order to promote efficient pricing of the contracts. It also
requires other characteristics of a liquid spot market, such as a large number of buyers and sellers,
large available capacity, and the concentration of trading in one or several locations. An active
spot market for transportation contracts provides scope for a financial transportation market,
where market participants can minimize the price and basis risks in the transportation market.

Markets in other segments of the gas industry

Increasing deregulation and restructuring of the natural gas industry leads to the emergence of
markets in other segments of the industry. Unbundling and open access, for example, give rise to
markets in natural gas storage, metering and installation of meters, construction of pipelines, and
pipeline system balancing.

Storage

Unbundling pipelines gives natural gas storage a new role in natural gas and transportation
markets in addition to its traditional role of load balancing.8 As a natural gas industry moves
toward structural model 4, storage is deregulated and storage operators become active in the gas
market, buying and selling natural gas as market conditions change. Storage can be crucial in
relieving pipeline congestion in local gas markets and helping to lower gas prices.

Deregulation of gas prices and the gas market creates plenty of profit opportunities for storage
facilities. Profit-maximizing storage operators look for markets where prices are high because of a
lack of competition or frequent congestion of the pipeline system. A storage facility can increase
competition in a local market because it becomes another player in the market, giving other
market participants another choice in selecting a supplier or buyer. And the success of one storage
facility can attract more operators, further increasing competition.

Deregulating storage operations can help relieve pipeline congestion. In a local gas market high
seasonal variation in natural gas prices may reflect pipeline capacity constraints in peak periods. A

8
Load balancing preserves the balance between injections and withdrawals of natural gas in the pipeline system.
 21

storage operator can use the available pipeline capacity in off-peak periods, when natural gas
prices are low, to inject natural gas into storage, and then sell this gas in the local market for
higher prices during peak periods. The storage operator reaps the benefits of high peak prices, but
it also pushes peak prices toward competitive levels because the availability of natural gas from
storage relieves congestion, at least partially. And its high profits will attract additional storage
facilities to the market, which will further lower prices.

But storage operators face two major problems in deregulated gas markets. The first is linked to
volatile gas prices, which introduce much uncertainty into decisions about the size and location of
a storage facility. Since most storage profits come from location- and time-based price arbitrage,
being able to predict future prices is crucial. Storage operators benefit greatly from price
discovery in the financial gas market, which provides efficient signals about future natural gas
prices. If the financial gas market is not developed, storage operators can reduce price uncertainty
by signing a long-term supply or purchase contract.

The second problem is linked to regulation of storage. Despite its increasing commercialization,
storage still serves as a tool to balance load in the pipeline network. If a storage facility serves
both functions, it becomes subject to regulation because of its link to the regulated pipeline
transportation segment. But distinguishing the costs associated with load balancing from the costs
associated with regular commercial operation is difficult, so determining the charges for load
balancing is a complicated and imprecise exercise. The remedy is to create a balance market,
where a pipeline company trades system imbalances with other participants in the gas market (see
the section below on the balance market).

Metering and installation of meters

A market in metering emerges as a result of the introduction of retail competition in model 4.

Metering becomes an important element in retail competition because suppliers must know how
much natural gas each consumer uses. Initially, all metering facilities are controlled by a
distribution company. But independent suppliers, fearing that the distribution utility will exercise
market power and provide low-quality metering services, will demand independent metering
services. An opportunity is thus created for new entrants to install new meters or take over old
ones, and to sell metering services to independent suppliers, distribution utilities, and end users.

Independent metering is limited by the costs of metering and installation, however. Suppliers and
end users will probably find that the costs of metering at residential sites outweigh the potential
savings because of the prohibitive costs of new metering devices and the low potential benefits.
Independent metering has developed mainly for large and medium-size consumer sites, while small
sites are still served predominantly by distribution utilities. Only the introduction of low-cost
metering technology can promote increasing use of independent metering and eliminate the ability
of distribution companies to restrict retail competition through inferior metering.

Construction of pipelines
 22

A market in construction of new pipelines emerges when deregulation of pipeline transportation

allows construction and operation of natural gas pipelines by third-parties. This decentralized
pipeline expansion regime can be introduced in structural models 3 and 4. (A centralized regime
allows pipeline construction only by pipeline companies.)

New pipeline capacity is added when market participants find it more beneficial to construct new
capacity than to pay a congestion rent. Under a decentralized regime a pipeline company operates
as a contract carrier and does not have an obligation to construct new capacity. If demand grows
beyond available capacity in a location, market participants will face high spot prices for natural
gas in that location because of the resulting congestion. Once the expected present value of
congestion payments (congestion rent paid to a pipeline company or congestion premiums paid to
gas traders) exceeds the present value of the costs of constructing and operating a pipeline,
market participants will add to pipeline capacity.

Three important factors affect the efficiency of the decentralized capacity expansion regime. First,
locational spot markets must be liquid and deregulated to generate efficient signals about the
market value of natural gas. An efficient spot market enables market participants to estimate the
congestion rent in a particular location by comparing spot market prices among locations.

Second, charges for transporting natural gas between locations should not distort locational spot
pricing of natural gas. Regulation of transportation rates must ensure that all participants in the
gas market face the same rates for transportation if they demand qualitatively and quantitatively
identical services. In addition, regulators should promote trading in the secondary transportation
market because it facilitates efficient pricing of pipeline capacity and reveals information about the
size of the congestion rent.

Third, cooperation between new and incumbent pipeline companies is important to promote
functional integration of their pipelines. If two pipelines fail to coordinate their transportation
services, transactions between participants connected to the different pipeline systems will be
difficult. So, to ensure efficiency, the incumbent pipeline company and an independent pipeline
operator should agree on a mechanism to facilitate transactions through their pipeline
interconnection.

To increase revenues and reduce average costs, an independent pipeline operator should consider
providing open access to its pipeline to parties that did not participate in the pipeline’s
construction. Benefits from operating a pipeline can be distributed among its owners on the basis
of their contributions to the construction costs. If the new pipeline experiences congestion in the
future, the pipeline owners can more than recover their investment through congestion rents.9

Balance market

9
Whether pipeline sources can recover their investment congestion rents depends on the type of regulation of
transportation charges. A pipeline operator can earn congestion rents only if it can charge prices based on the
short-run marginal cost of transportation. See Harvey, Hogan, and Pope, 1996.
 23

A balance market is a market where pipeline system imbalances are traded through an auction. A
system imbalance arises when there is a difference between the volume of gas flows and the
available capacity in the pipeline system. A system imbalance can occur any time that shippers do
not maintain their individual balances— the balances between their nominated and actual gas
shipments. The balance market can first appear in model 3 or 4, but so far its practical
implementation has been limited to the United Kingdom. A balance market was created there in
1996, when British Gas was unbundled into a gas supplier and a pipeline system operator.

The balance market is closely linked to the operation of the pipeline system. A pipeline operator
must maintain a balance between injected and withdrawn natural gas to ensure the safety and
reliability of transportation services. The operator achieves a balance by scheduling gas flows for
the following day on the basis of shippers’ nominations, the information shippers provide about
desired directions and volumes of shipments. The operator then runs the pipeline system
according to the schedule and monitors injections and withdrawals in real time.

But before the gas day, the pipeline operator invites shippers to bid for system imbalances. The
imbalances can be positive or negative, depending on whether there is an excess or shortage of
natural gas in the system. Shippers send bids stating how much gas they are willing to buy or sell
if a system imbalance occurs, and at what price. If the system runs into an imbalance, the
operator determines how much natural gas it must buy or sell to restore balance and then accepts
the bids that do so at the lowest total cost. The operator pays the winning bidders a price equal to
the price of the last bid accepted. If the bidding for system imbalances is competitive, this price
reflects the system’s short-run marginal cost of gas.

An efficient balance market produces information with wide utilization in the deregulated gas
industry. The prices generated by the balance market can be used for pricing the load balancing
services provided by storage facilities to pipeline companies. The price of a system imbalance
reflects the costs that the imbalances of individual shippers imposed on the pipeline system, so the
pipeline operator knows exactly how much it must recover from undisciplined shippers. Finally,
the cost of restoring system balance signals the pipeline operator when to use the balance market
and when to curtail gas flows.
 24

Trading Models in the Deregulated Natural Gas Industry

Trading mechanisms guide transactions in natural gas and transportation markets. They facilitate
interactions among market participants with the objective of achieving simultaneous clearing of
natural gas and transportation markets at minimum cost to the gas industry.

Deregulation of the natural gas industry leads to separate trading of natural gas and transportation
services, which increases the complexity of markets and imposes substantial requirements on
market participants if they are to complete all their transactions at the minimum cost. While a
vertically integrated gas company optimizes all transactions internally, participants in a
deregulated gas industry must coordinate their natural gas and transportation transactions in an
open market. The process of minimizing the total cost of natural gas and transportation to the
industry must take place across thousands of decentralized transactions. Unless these transactions
are guided by a trading model, they can result in suboptimal allocation of resources.

Two distinct trading models have been developed: a bilateral trading model and a poolco model.
Both models achieve market clearing at the minimum cost, though in different ways. The main
differences between the models are in the nature of transactions and in the way the transactions
are coordinated in natural gas and transportation markets.10

Bilateral trading model

The bilateral trading model is based on decentralized bilateral transactions. The model relies on
competitive gas and transportation markets to generate efficient prices and minimize the cost of
natural gas to the end users.

Decentralized spot markets

In the bilateral trading model market participants conclude all deals in bilateral negotiations and
write contracts that address all issues relevant to a transaction. Demand for ways to minimize of
transaction costs leads to the emergence of traders who complete transactions on behalf of other
market participants. Spot markets develop as market participants require efficient pricing of
natural gas at every moment. Spot markets are thus developed through the decentralized action of
market forces.

Competitive spot markets generate signals about the market value of natural gas and give market
participants the right incentives to complete transactions efficiently. As a result, decentralized
bilateral trading among market participants achieves the outcome that is optimal for individual
participants as well as for the natural gas industry as a whole.

Distance-based pricing of transportation

10
The following sections draw heavily on the excellent discussion of trading models in Hunt and Shuttleworth
1996.
 25

Charges for transportation services sold in the primary transportation market are based on the
fixed and variable costs of a pipeline company per unit of distance over which individual
shipments take place. A capacity charge is set to recover total fixed costs, while a throughput
charge is used to recover the variable costs of transporting natural gas. Transportation contracts
sold in the secondary market are priced according to the short-run marginal cost of capacity.

A competitive secondary capacity market and the availability of many different firm and
interruptible transportation contracts enable shippers to match their needs for natural gas with
transportation services. They form a portfolio of transportation contracts that gives them the
minimum acceptable reliability of transportation at the minimum cost. Because each shipper is
able to minimize its total cost of natural gas and transportation, the total cost of natural gas to end
users is minimized.

Direct access in retail competition

In the bilateral trading model retail competition takes place among suppliers who compete by
price for power supply contracts. End users can choose a supplier of natural gas, which is then
responsible for arranging transportation of natural gas to the consumption site. This structure, in
which end users enter into supply contracts with suppliers, is referred to as “direct access.”

Suppliers charge end users a single price for a unit of delivered natural gas. Competition among
suppliers ensures that the retail price is equal to the sum of the wholesale gas price plus the
distribution fee. Since suppliers have the ability to acquire natural gas and transportation services
at the minimum cost, end users face optimal retail prices. So all transactions in the natural gas
industry lead to the socially optimal outcome.

Poolco model

In the poolco model transactions are coordinated by a single entity, which ensures that all
transactions in natural gas and transportation markets are completed at the minimum cost to
society. The poolco model is based on the notion that decentralized bilateral transactions do not
always lead to the socially optimal outcome in the gas industry because of the technical
characteristics of natural gas pipeline systems.11

Pool operator

Transactions in the natural gas market are facilitated by a pool operator, an entity assigned a
market clearing responsibility by the regulator. Market participants inform the pool operator how
much natural gas they want to purchase or sell and at what prices they are willing to complete
transactions. The pool operator aggregates this information into system supply and demand and

11
This argument is taken from the context of the electric power industry. Like an electric power transmission grid,
a natural gas pipeline system exhibits network externalities that affect loads in two separate locations. A gas
shipment from one location can reduce the capacity available to shippers in an adjacent interconnected pipeline.
However, the operator of a pipeline network has more options for controlling loads and flows in real time than the
operator of a power transmission grid.
 26

calculates the system price that will clear the market. This procedure is repeated at short intervals
to generate continuous pricing of natural gas.

The pool operator can divide the natural gas market into several local markets (nodes) if there is
insufficient pipeline capacity to move natural gas between locations. It would then determine
prices for each node using the same procedure.

The system price reflects the market value of natural gas. Competition among natural gas
suppliers and buyers ensures that system prices reflect the short-run marginal costs of natural
gas— that is, that they are efficient. Because all market participants complete transactions at
system prices or their derivatives the outcome of trading under the poolco model is socially
optimal.

Locational pricing of transportation

Transportation is sold as a service that takes natural gas in or releases it from the pipeline system
at a particular location. Shippers buy entry and exit capacity at points of injection and withdrawal
from a pipeline company or other shippers. They order transportation services by nominating the
volume of natural gas they want to ship through the pipeline system on the next day. A pipeline
company reviews the nominations of all shippers and determines the schedule of gas flows that
minimizes the total cost of transportation. If some capacity remains after the nominations of firm
shippers have been accounted for, the pipeline company offers interruptible services to other
shippers. Gas flows in the pipeline system do not always follow the “contractual paths” because a
pipeline company can often find a more optimal way to direct flows through the system.

The prices of transportation services are based on the market value of capacity and throughput at
the entry or exit point and thus reflect the short-run marginal cost of capacity and throughput.
Prices vary in time and across locations, reflecting differences in the market value of capacity (the
marginal cost of throughput tends to be small and constant). A pipeline company determines the
value of capacity as the difference between nodal prices of natural gas, because this difference
reflects the congestion rent earned by a congested pipeline. Competitive local gas spot markets
generate efficient signals about the size of the congestion rent, ensuring that shippers pay efficient
prices for transportation services and can make optimal transactions in natural gas and
transportation markets.12

Virtual access in retail competition

Under the poolco model retail competition takes place among suppliers who compete by price for
financial gas contracts. End users receive physical delivery of natural gas from the local
distribution utility, which charges only for transporting the gas through distribution pipelines and
fully passes through the prevailing nodal price of gas to the end users. As a result, end users face

12
But shippers face price risk in the transportation market if capacity prices are based on the short-run marginal
costs. To enable shippers to minimize price risk, a financial transportation market must be created .
 27

spot prices, but they cannot choose another gas supplier, a structure referred to as “virtual
access.”

End users are exposed to price risk because they face volatile spot prices. Suppliers therefore sell
them insurance plans— financial gas contracts that stabilize retail prices by minimizing price risk—
and end users choose among suppliers based on the insurance premiums. Competition among
suppliers ensures that premiums are efficient, reflecting the risk aversion of end users and the
costs of hedging. Because end users face both efficient spot prices for natural gas and efficient
insurance premiums, the outcome of all transactions in the natural gas industry is socially optimal.

The bilateral versus the poolco model in the natural gas industry

If properly applied, the bilateral and poolco trading models both lead to the same outcome. Which
model is more appropriate for a country depends on the characteristics on its natural gas industry.
Countries with relatively large gas markets can rely on the decentralized actions of market forces
to develop a liquid and competitive spot market and could therefore opt for the bilateral model.
Smaller countries may find it necessary to speed up the development of a spot market by
establishing a pool operator that facilitates market clearing in the gas and transportation markets.

The structure of a pipeline system also affects the choice of trading model. Pipelines with a trunk
line structure are ideal for the bilateral model because network externalities are small. By contrast,
a pipeline system structured as a dense network exhibits network externalities because loads in
one line affect loads in another one. And since bilateral transactions do not take into account load
interdependencies, market participants can require transportation services that do not minimize
total transportation costs. In this case, then, the poolco model is more appropriate, because it
allows the pipeline operator to determine the optimal gas flow schedule regardless of contractual
paths.

Transactions in the bilateral trading model are relatively simple. Because they are bilateral, they
are easy to complete and understand even in complex markets. By contrasts, transactions in the
poolco model place enormous information requirements on the pool operator, which must have
access to information about the availability, prices, and costs of natural gas and transportation. As
a result of these information requirements, the prime candidate for the job of pool operator is a
pipeline company, which has the best information about the pipeline system— information difficult
to obtain in a decentralized market. An alternative candidate is an independent entity jointly
owned by all participants in the gas industry. In such a case, the pool operator must establish
confidentiality rules to ensure all participants that sensitive information will be well protected.

Application of these two trading models in the natural gas industry has been uneven. Almost all
countries have opted for the bilateral trading model, because it is simpler to implement than the
poolco model. In these countries, natural gas trading takes place primarily as a bilateral
transaction in decentralized spot markets and retail competition, if introduced at all, is based on
the direct access scheme, in which end users conclude physical gas contracts with suppliers. The
poolco model has been applied only in the United Kingdom, and there only to a limited extent.
 28

A typical example of the bilateral trading model exists in the gas industry in the United States,
where natural gas spot markets have developed as a result of deregulation during the past six
years. Resale of transportation contracts has led to the development of a secondary transportation
market and promoted variability in transportation contracts. Trading takes place on a bilateral
basis in a competitive market. Transaction costs are minimized through the use of natural gas
marketing companies and electronic trading systems that aggregate information about the
availability and prices of natural gas and transportation across regions. Competition and
transparency in the gas and secondary transportation markets promote efficient pricing of natural
gas and transportation contracts. And because market participants can coordinate transactions in
both natural gas and transportation markets, they can minimize their total cost of natural gas and
transportation.

In the limited version of the poolco model in the U.K. gas industry, British Gas TransCo, a
pipeline system operator, optimizes gas transportation regardless of the contractual paths. It has
organized a spot market for natural gas, called the “on-system” market, and a spot market for
system balances, the “flexibility” market. All other transactions in the gas industry are completed
on a bilateral basis.

British Gas TransCo optimizes gas flows through the pipeline system on the basis of the principle
of minimizing total transportation costs. Shippers purchase entry and exit point capacity and
notify the operator about the volumes and locations of injection and withdrawal. The optimal
transportation schedule determines gas flows regardless of the transactions by shippers in the
natural gas market.

On-system trading takes place among shippers when they exchange ownership of natural gas that
has been injected into the pipeline system. The pipeline system operator plays the role of a
“natural gas exchange” to facilitate natural gas transactions, but it does not determine the system
price of natural gas. Instead, prices are set by market participants in decentralized bilateral
negotiations. On-system trading therefore combines the bilateral and poolco trading models.

In the balance, or flexibility, market, which is representative of poolco-style gas trading, the
operator receives bids for sale or purchase of natural gas from other market participants. If the
pipeline system experiences an imbalance, the operator accepts the bids that minimize the cost of
restoring system balance. Shippers whose bids are accepted are paid the system price that is equal
to the price of the last bid accepted (see Juris forthcoming a).
 29

References

Berg, S., and J. Tschirhart. 1988. Natural Monopolies Regulation. Cambridge: Cambridge
University Press.

Braeutigam, R.R. 1989. “Optimal Policies for Natural Monopolies.” In R. Schmalensee and R.D.
Willig, eds., Handbook of Industrial Organization. Vol. 2. Amsterdam: North Holland.

Harvey, S., W. Hogan, and S.L. Pope. 1996. “Transmission Capacity Reservations and
Transmission Congestion Contracts.” Harvard Electricity Policy Group. Harvard
University, Cambridge, Mass. Draft.

Hunt, S. and G. Shuttleworth. 1996. Competition and Choice in Electricity. Baffins Lane,
England: John Wiley & Sons.

Juris, A. Forthcoming a. “The Development of Markets in the U.K. Natural Gas Industry.” Policy
Research Working Paper. World Bank, Private Sector Development Department,
Washington, D.C.

— — . Forthcoming b. “The Development of Natural Gas and Pipeline Capacity Markets in the
United States.” Policy Research Working Paper. World Bank, Private Sector
Development Department, Washington, D.C.

Laffont, J.J., and J. Tirole. 1993. A Theory of Incentives in Procurement and Regulation.
Cambridge, Mass: MIT Press.

NYMEX (New York Mercantile Exchange). 1996. “Glossary of terms.” http://www.nymex.com.

U.S. Department of Energy, Energy Information Administration. 1995. Natural Gas 1995: Issues
and Trends. DOE/EIA-0560. Washington, D.C.
Figure 1 Model 1: Vertically Integrated Natural Gas Industry

Pipeline
Production Distribution End users
transportation

Gas transportation Gas supply transactions

Figure 2 Model 2: Competition among Natural Gas Producers

Producer

Pipeline
Producer Distribution End users
transportation

Producer

Gas transportation Gas supply transactions

Figure 3 Model 3: Open Access and Wholesale Competition

End users

Residential

Commercial

Pipeline Distribution
Producers
company utility
Industrial

Wholesale Traders and

market suppliers
Electric
utilities

Gas transportation Gas supply transactions

Figure 4 Model 4: Unbundling and Retail Competition

End users

Residential

Commercial

Pipeline Distribution
Producers
company company
Industrial

Spot Traders and

market suppliers
Electric
utilities

Gas transportation Gas supply transactions

Figure 5 Transitional Model: Unbundling of Pipeline
Transportation and Open Access to Distribution
End users

Residential

Commercial

Pipeline Distribution
Producers
company utility
Industrial

Traders and
Spot suppliers
market
Electric
utilities

Gas transportation Gas supply transactions

Figure 6 Structure of the Wholesale Gas Market

Model 2

Producers Gas utility

Model 3

Distribution
Producers utility

Pipeline Traders and

company suppliers

Model 4

Traders and
Producers
suppliers
Figure 7 Structure of the Retail Gas Market
Models 1 and 2

Gas utility End users

Model 3
Distribution Small
utility end users

Pipeline
company

Suppliers Large
end users

Distribution
utility

Model 4

Suppliers End users

 References

Berg, S., and J. Tschirhart. 1988. Natural Monopolies Regulation. Cambridge: Cambridge
University Press.

Braeutigam, R.R. 1989. “Optimal Policies for Natural Monopolies.” In [first initial?]
Schmalensee and R.D. Willlig, eds., Handbook of Industrial Organization. Vol. 2.
Amsterdam: North Holland.

Harvey, S., W. Hogan, and S.L. Pope. 1996. “Transmission Capacity Reservations and
Transmission Congestion Contracts.” Harvard Electricity Policy Group. [Harvard
University, Cambridge, Mass.?] Draft.

Hunt, S., and G. Shuttleworth. 1996. Competition and Choice in Electricity. Baffins
Lane, England: John Wiley & Sons.

Juris, A. Forthcoming a. “The Development of Markets in the U.K. Natural Gas Industry.”
Policy Research Working Paper. World Bank, Private Sector Development
Department, Washington, D.C.

— — — . Forthcoming b. “The Development of Natural Gas and Pipeline Capacity Markets

in the United States.” Policy Research Working Paper. World Bank, Private Sector
Development Department, Washington, D.C.

Laffont, J.J., and J. Tirole. 1993. A Theory of Incentives in Procurement and Regulation.
Cambridge, Mass.: MIT Press.

NYMEX (New York Mercantile Exchange). [insert year in which information was
obtained from the Website] “Glossary of terms.” [insert the Website address].

U.S. Department of Energy, Energy Information Administration. 1995. Natural Gas

1995: Issues and Trends. DOE/EIA-0560. Washington, D.C.